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Vanguard ETF Shares are not redeemable with the issuing Fund other than in Creation Unit aggregations. Instead, investors must buy or sell Vanguard ETF Shares in the secondary market with the assistance of a stockbroker. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

Investments in bond funds are subject to interest rate, credit, and inflation risk.

Diversification does not ensure a profit or protect against a loss in a declining market.

Stocks of companies in emerging markets are generally more risky than stocks of companies in developed countries.

An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in such a fund.

All investing is subject to risk, including possible loss of principal.

It’s still early in the new year, and there’s lots to worry about in the investment domain and in the broader world. But one item tops my “worry list” for 2010: interest rates. And it’s hard to decide which is the greater worry—the status quo, or a change in it.

The status quo for rates is simply unbearable. Money market yields are below .05%. I just rolled over a CD at 1.1%. Conservative savers and income investors are reeling.

The unprecedented level of short-term rates is of course a conscious policy of the Federal Reserve. The textbook economics argument is that low rates are needed to stimulate the economy, but overnight money at 2% would actually do the trick. Instead, today’s exceptionally low rates are a policy instrument to support the banking sector.

Thus, my bank borrows from me and other CD investors at 1%, and it is also refinancing my mortgage at 4.25%, pocketing the spread. Gains from this type of transaction are offsetting losses on bad mortgages from earlier years. It’s a great deal—an historically exceptional deal—for borrowers. (If you have a mortgage and haven’t refinanced, you should look into it—now.) But not for yield-hungry savers and investors, who are paying for the policy in the form of depleted investment income.

Over the past year, we have also seen the inevitable reaction of investors to a low-rate environment—a shift out the yield curve. Assets have poured into bond funds as investors and savers have sought higher nominal yields. Last night, as I started writing this, 10-year Treasury bonds were yielding 3.65%—not the golden 5% yield that so often catches the attention of retail investors, but certainly a lot more than 0.5% or 1%. It’s not only individual investors who have the bond bug. 401(k) plan administrators want to add bond fund options for their workers, partly in reaction to the ’08/’09 decline; managers of traditional defined benefit pensions are also shifting to bonds to manage their plan liabilities.

And therein lies the risk of a change in the status quo: a sudden rise in longer-term interest rates, and plunging bond prices. Many investors may remember 1987 for the sudden stock market crash that occurred on Black Monday, October 19. I remember the spring of 1987 instead, when bond yields soared and bond prices plunged by 10% or more over a short period. It’s not inconceivable to imagine the following scenario: The bond market—anticipating stronger economic growth, and perhaps spooked by an inflation report and a shift in Federal Reserve policy—pushes current Treasury 10-year yields to 5% in a hurry, driving bond prices lower.

Perhaps all bond fund investors are smarter than they were in 1987. Perhaps many are permanently shifting portfolios away from equities to bonds, and they plan to ride out any fluctuations in bond prices. Perhaps. Odds are, a lot of the money in Treasuries and other fixed income instruments is there because investors are thinking these investments are substitutes for cash, which they aren’t. Or investors are thinking they can time changes in interest rates and shift to cash at just the right moment, which they can’t.

Meanwhile, for all of the equity investors out there (which is most of you), here’s another wrinkle. Higher rates mean that fixed income investments become more appealing than equities, all things equal. They also mean that the prices of stocks (based on the discounted present values of future dividends) will be lower. In other words, in most scenarios, rising rates mean stagnating, or falling, stock prices.

Stocks rose sharply last year in the face of the receding risks of Depression 2.0. If rates rise in 2010, stocks will come face to face with their traditional nemesis: the “wall of worry” known as rising rates.

For the patient long-term investor, the strategy is to stick with your investment plan and ride out the fluctuations. Just be prepared for the bond market crisis, if it ever arrives, and steel yourself for the volatility. For the panicky investor, now is the time to revisit your portfolio—before, not after, the possible damage.

Note: All investments are subject to risk. Investments in bond funds are subject to interest rate, credit, and inflation risk.

Like this:

Steve Utkus

Steve Utkus oversees the Vanguard Center for Retirement Research, which studies many aspects of retirement in America—from how individuals start saving and investing in the early part of their careers, to how they prepare for actual retirement, to how they spend down their savings once they’re retired.
Steve is particularly interested in behavioral finance—the study of how rational decision-making is influenced by human psychology. His current research interests also include the ways employers design retirement programs, and new developments in retirement in other countries.
Steve holds a B.S. from the Massachusetts Institute of Technology and an M.B.A. from the University of Pennsylvania's Wharton School. He began working at Vanguard in 1987 and has served as director of the Center for Retirement Research since 2001. Steve is also a visiting scholar at the Wharton School.

Anonymous | May 26, 2010 9:22 am

Anonymous | May 15, 2010 2:21 pm

I agree with those asking for advice, not reasons to worry. I can come up with reasons to worry on my own. Why doesn’t Vanguard offer bond mutual funds with fixed maturity dates so if the investor stays in the fund, they will get their principal back (adjusted for the premium or discount at time of purchase)? I know that such funds are being offered by one fund family, why not Vanguard.

Anonymous | May 6, 2010 10:45 pm

I agree that interest rates are likely to go up – but of course the timing is always unknown. I happen to have cash to invest and the advisors I have spoken to at Vanguard suggest more diversification into bonds. But for the life of me, I can’t figure out why I shouldn’t wait on this. Isn’t treading water with cash preferable to buying bonds now at these very low rates?

Anonymous | February 1, 2010 11:07 pm

Anonymous | February 1, 2010 8:03 pm

Your blog is excellent. If the markets really were free it would be easier to accept the situation we are in currently. However, the Federal Reserve, I believe, is manipulating to an uprecedented degree the bond and the equities markets. They’ve trashed the money markets to make sure the banks are making money and forced people who need returns to invest in the bond markets where the Fed is purchasing treasuries to keep yields low on those as well. Soon they will stop purchasing bonds and down the road will cause interest rates to go up in the money markets thereby taking the bond returns away from those investors whom they originally forced out of money markets. Once they start raising short term interest rates, the people whom they incentivized to invest in equities will lose because the stock market will founder a bit because of higher borrowing costs. And they are already looking for a new way to game the system as far as what method they will set short term rates and then yank liquidity. And who knows what inflation will be? Free marketplace indeed.

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Visit vanguard.com or contact your broker to obtain a Vanguard ETF or fund prospectus which contains investment objectives, risks, charges, expenses, and other information; read and consider carefully before investing.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in Creation Unit aggregations. Instead, investors must buy or sell Vanguard ETF Shares in the secondary market with the assistance of a stockbroker. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

Investments in bond funds are subject to interest rate, credit, and inflation risk.

Diversification does not ensure a profit or protect against a loss in a declining market.

Stocks of companies in emerging markets are generally more risky than stocks of companies in developed countries.

An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in such a fund.

All investing is subject to risk, including possible loss of principal.